In case you didn't get the memo; modern portfolio theory has
Almost all asset classes are now extremely highly correlated,
which is a very new thing. Have you noticed that when stocks
rise, commodities are also up? When the Euro is up, the
U.S. stock market is also up? When the housing market jumps,
so do other assets. Even when bonds are rallying, so are
stocks. Energy (NYSEARCA:XLE), financial (NYSEARCA:XLF),
health care (NYSEARCA:XLV), European (NYSEARCA:VGK), and even
Japanese (NYSEARCA:EWJ) stocks all rise and fall together, much
more so than historically. You get the picture.
Correlations across asset classes in reality are at all time
highs, and in my article entitled, "
Are Rising Correlations a Threat to Your
I touched the surface on the new world we live in and showed that
correlations are at levels never before seen.
This alone presents great risks for a "diversified"
portfolio, but how can we can use this new world disorder to our
What does Junk have to do with it?
If there is one investment category that does belong
in the same discussion as "highly correlated" with equities, it is
junk bonds. These types of high risk bonds behave and act more like
equities than any other bond class.
Junk bonds, or if you prefer the more socially acceptable
description, "high yield debt", are typically the final tranches of
debt a company takes out. They are the last debt pieces to
get paid back during times of distress and the first tranches to
default. Because of this increased risk, speculative grade
debt pays higher yields than more secure and safer
The latest estimates by S&P put the speculative grade bond
market around $2.2 trillion in size, which makes this market much
larger than most would likely assume. Based on S&P's junk
classification this includes all bonds that have a rating of BB+
(or Ba1 for Moody's). However, junk still remains just a
small slice of the total U.S. bond market which is around $37
trillion (compared to a U.S. equity market (NYSEARCA:VTI) around
Junk bonds historically have always been highly correlated with
equities. Because of this historical relationship we can use
high yield debt (NYSEARCA:HYG) price movements compared to equity
price movements to find warning signs, red flags, and trade
The best way to see the junk (NYSEARCA:JNK) and the equity
markets' (NYSEARCA:SPY) high correlations along with some potential
trading signals is by perusing some historical charts.
The first chart below shows the five year history of the ETFs
that track the S&P 500 (SNP:^GPSC) and the high yield bond
Notice the extremely high correlation through time? That
shows that JNK and SPY (NYSEARCA:SPY) price movements behave very
similar through time, sometimes approaching identical.
It also shows that whenever correlation dips near zero (prices
are behaving differently), it eventually bounces back, approaching
1.0 (prices are behaving almost identically).
Bonds are Smarter
An old saying on Wall Street is that the bond market is smarter
than the equity markets. Two of the reasons for this are
because it simply is much larger and thus more scrutinized. Also,
the bond market has very few direct retail buyers.
Ignore the VIX to Your Own Peril
As mentioned above, the bond market (NYSEARCA:BND) is over 50%
larger than the equities market in asset value. But given
that bonds are also reissued every few years on average and stocks
typically are not, the turnover value of the bond market is
exponentially larger than the equities market. New issues of
bonds are issued daily, whereas new companies going public are
weeks or months in between. The bond market (NYSEARCA:BOND)
simply dwarfs the equities market.
The equity market also is a secondary market where buyers and
sellers of all kinds exchange shares. The bond market however
has very few retail investors participating directly in it.
Because of this the bond market it is said to be more
For these and other reasons we turn to the bond market
(NYSEARCA:AGG) for the smarter, or "correct" signals of the
Recent Junk Signals
Looking at the junk bond market's signals more recently and
shown by the next chart analysis, there were some telling signs
warning of the recent short term equity peas.
During the equity markets' May topping process, Junk had already
peaked and turned down two weeks earlier.
Again in July, the junk debt market peaked two weeks before the
These two peaks in the junk market warned of weakness to come in
the equity markets.
Today junk remains in a downtrend, making 2 lower highs with one
today testing that downtrend as shown in red on the chart.
T his is occurring as stocks are making new highs.
If JNK continues higher, it will confirm the breakout in
equities. However, if JNK stays below its July peak, it will
again warn that the equity market rally will likely be short lived
as JNK has been warning since May that the uptrend is not as strong
as equities suggest.
There are also a few other ways to take advantage of the high
correlation and warning that high yield debt is currently sending
the equity markets including a market neutral pairs trade and other
ways to take advantage of a continued rally in JNK. I follow
these and other trade setups in our twice weekly Technical
Profit Strategy Newsletter
and Technical Forecast use technical, sentiment, and fundamental
analysis to stay ahead of the markets. Right now the smarter
bond market does not trust the equity rally since May, and it may
be warning us again that this renewed equity rally will be short
Follow us on Twitter @